WASHINGTON — In 1992 George Soros sold short more than 10 billion pound sterling. He bet that the British government would devalue its currency and withdraw the pound from the European Exchange Rate Mechanism (ERM), the precursor to the euro. By locking exchange rates within certain ranges, the ERM helped provide stability across European markets.
It was doomed to fail. Since the European countries' individual economies could diverge, their leaders had a hard time staying committed to the ERM. Financial markets knew this. After Soros' move, the pound left the ERM and Soros became the “man who broke the Bank of England.”
In recent months Europe’s common currency regime has again been cast into doubt, as some eurozone countries have run into serious fiscal problems, particularly Greece but also Spain and Portugal. Speculators have been betting against the survival of the euro. A Greek exit from the euro no doubt crossed their minds. Governments have once again entered the fray to battle the markets as a wider European sovereign debt crisis has emerged. After a 110 billion euro bailout for Greece failed to cool markets, the European Union and International Monetary Fund announced an enormous 750 billion euro plan to be made available to all 16 eurozone members. Despite initial euphoria by financial markets, a new cloud of uncertainty now hangs over the future of the European project.
What brought Europe to this point? The euro has provided a stable unit of currency helping facilitate trade, investment, and growth. As an emblem of European solidarity, it remains a major milestone in the history of the European project, which has expanded peace and prosperity in Europe and to its neighbors since the end of World War II. Yet, embedded in this European narrative has been the assumption that poorer members will rise to the level of the wealthier ones. This aspiration has not been fulfilled.
After adopting the euro, policymakers gained a reliable unit of exchange, but could no longer devalue their currency in times of trouble. Instead, eurozone countries were expected to reform their labor and product markets, making them more flexible, and trim excessive public sectors. As markets become more competitive, integrated and productive, economic growth would expand the pie pulling up the poorest members. EU Treaties established sanctions against eurozone countries that did not live within their means (i.e. ran excessive deficits). The European Central Bank’s mandate to ensure price stability helped to anchor monetary policy.
This is where things went wrong. Enforcement of deficit limits has been farcical, market reforms limited, and in the case of Greece outright fraud perpetrated (the previous government cooked the books). All of these factors undermined investor confidence. Greece, Spain and Portugal face higher costs when raising cash from investors demanding greater return for their risk. For weeks European policymakers sought to contain the crisis to Greece. But the financial turmoil spilled over to wider European markets with the potential to unhinge the nascent global economy recovery. As investors seek to compensate for losses in one market they sell in others, leading to financial contagion where even the fiscally prudent can suffer.
Even if the recent aid package calms markets, Europe faces more serious, enduring systemic challenges. Where the EU had failed to impose long overdue reforms, the IMF is now doing the job. European leaders were reluctant to have the IMF involved precisely because it revealed their inability to get their own house in order. Given the vast literature and policy debates since the creation of the euro — all pointing to the need for competitiveness-enhancing policies among euro member laggards — it’s hard to believe that policymakers were unaware of what was required to be responsible members of the eurozone until now.
The European Central Bank has agreed to buy government bonds of countries in trouble. This puts money into the financial system and eases the flow of credit. Until recently this option was vehemently opposed, especially by Germany which lives with the legacy of hyperinflation from the 1920s. Independence from political influence is the cornerstone of a central bank’s credibility. When monetary policy is driven by the whims of bureaucrats and not clear rules that provide confidence to markets, a central bank becomes ineffective.
Growth will be the biggest challenge. The fiscal austerity, pension cuts, and reforms imposed on Greece will be brutal and arguably will not lead to the deep reforms necessary to purge the country’s Third World-like corruption and nepotism. Even if all goes well, Greece will see its debt reach 140 percent of GDP and economic stagnation over the next three years. Spain and Portugal are looking at spiraling debt and severe economic weakness. In the absence of growth, jobs, and funds for public goods like health and education, social cohesion will be strained.
Europe needs more than an aid package. It needs an aggressive growth agenda coupled with effective tools to manage economic divergence. Only then will the potential gains from a common currency be reaped.
Jonathan White is a senior program officer in the economic policy program of the German Marshall Fund of the United States.